The coronavirus, or Covid-19 pandemic is an economic Black Swan which has thrust the world onto a path to an economic collapse of epic proportions. In this constantly-updated blog we follow the progress of the crisis.
The Stage of the Crisis: Counterattack/Flood
Updated 02/06/2020 (previous update 26/05). All updates are presented in bold.
In the December 2018 issue of our Q-Review, we outlined the likely scenarios of an approaching global economic collapse. But, like most things in life, such a dramatic event is unlikely to proceed in a linear fashion. There will be different stages within it.
In December 2019 we outlined these stages, which are likely five: the onset, counter-attack, flood, calamity and recovery. Here, we briefly define the characteristics of each updating them with the recent information.
The Onset of the crisis
In the Q-Review 4/2019, we specified that at the onset, stresses that had been building in the credit markets since the summer of 2019 would explode, shrinking if not eliminating entirely the exits from many parts of that market.
Downgrades of corporate debt in the U.S. and peripheral sovereign debt in the Eurozone would push large fixed-income investors, including pension funds, into higher-rated bonds, which would in turn lead to large-scale selling of lower-rated bonds, forcing wider spreads and even more selling.
This moment came in late February 2020, when a sudden panic gripped investors in both credit and equity markets after a surge in reported Covid-19 deaths and cases in Italy combined with the collapse of OPEC talks. Stock markets crashed and spreads in the credit markets exploded. A frantic retreat to ‘safe-haven’ assets, including U.S. Treasuries, German Bunds and U.K. Gilts as well as cash and precious metals commenced.
For a brief period of time in mid-March, we were on the brink of a complete financial market meltdown. Then, as we also had envisaged in December, there was a frantic rush on a never-seen-before scale by global and local authorities to rescue the situation.
We envisaged that the second phase of the collapse would be the desperate efforts of authorities to stop the crisis by a counterattack.
We said these were likely to include the restarting and acceleration of QE programs and other market support initiatives, gigantic fiscal stimulus, increasing trade protectionism and possibly even calls for direct debt monetization (see Q-Review 3/2019 for an explanation).
These tactics are now in effect in full force. The U.S. government has applied an absurdly enormous stimulus program of $2 trillion with the possibility of much more to come. Governments all over the world have pushed vast amounts of debt-financed stimulus into their respective economies. This seriously undermines their ability to respond to future shocks, while simultaneously creating a massive number of “zombie corporations”.
In a historical move, the Bank of England announcedhat it will begin to finance the short-term needs of the Treasury. While the BoE stated that the debt monetization would be “temporary and short-term”, it will be no such thing. Below, we explain why.
The Fed has now become the financial market as it backstops “repo” and U.S. Treasury markets, intervenes in corporate commercial-paper and municipal bond markets and short-term money-markets, and buys corporate bond ETFs. In a recent move, the Fed announced it will include also some speculative-grade, or “junk” corporate debt in its buying program. There is not much left of the once-magnificent “free markets” in the U.S.
Massive support by the FED has levitated U.S. stock market valuations to levels not seen since, at least, the height of the “Tech Boom” in 1999. Taking into account the deteriorating economic landscape combined with high unemployment (with over 38 million) in the U.S. this has created an extremely precarious situation for the stock markets. There is no question that we are in the latter stages of a stock market mania.
Mohammed El-Erian recently published an influential article in which he warned that the policies of the Fed risk creating “zombie markets”, that is, markets that no longer send accurate price signals and that fail to play an efficient role in mobilizing and allocating capital. This has, in fact, already occurred in China and the Eurozone, and the US is not far behind now.
Germany’s Constitutional Court (CC) has set a potential roadblock to the “counterattack strategy” of the ECB by demanding in their recent ruling that the Bundesbank exit the Public Sector Purchase Program (PSPP), unless the ECB Governing Council adopts a new decision that demonstrates in a comprehensible and substantiated manner that the monetary policy objectives pursued by the PSPP are not disproportionate to the economic and fiscal policy effects resulting from the programme.
This may be impossible to achieve, because, for example, research by the Bank of Netherlands has found that the PSPP has contributed to the “exuberant price behavior“ in the sovereign bond markets of the Eurozone.
If the ruling of the CC is upheld, it will force the Bundesbank to exit PSPP, which would mean that the Bundesbank has a different monetary policy than the rest of the Eurosystem. Effectively, this would imply an Dexit or Germany’s exit from the Eurozone. It’s rumored that the ECB is drawing-up a “contingency plan” in case the Bundesbank exits the PSPP. We eagerly await what form such a plan could take.
These developments imply that the Counterattack phase is almost done.
If the desperate efforts of global authorities to uphold the credit and stock markets succeed, as it now seems they may, we will still be faced with a flood of corporate bankruptcies.
In December 2019, we asserted that the so-called “zombie” corporations, faced with collapsing global economic demand will start to fail on a scale unseen in decades. Unemployment will skyrocket and tax revenues will collapse. And, at some points, credit markets will crash despite of the massive efforts of central banks.
Next, we detail the Flood phase in three crucial countries/areas: the U.S., the Eurozone and China.
The United States
Unprecedented intervention by the Fed risks turning the U.S. economy into a massive “zombie”. Corporations that should be failing are getting cheap loans, enabling them to continue operating when their entire business model has crumbled.
The recent “Main Street” lending program has pushed the U.S. to the edge of socialism, because a government entity is now directly responsible for the financial fate of privately-owned businesses. This is truly a tragic development.
Yet, the simple fact is–as noted by J. Powell above–that corporate bailouts enacted by the U.S. government and the Fed will be unable to stem the “flood” of corporate bankruptcies once they get going. The negative economic momentum is just too massive.
The first signs of the “Flood” in the U.S. are now clearly visible. The bankruptcies of J.Crew Group and J.C. Penney, among other large American retailers, and the collapse of Hertz, an American-based global auto rental company giant, are the beginning.
It’s also estimated that one quarter of U.S. restaurants will not re-open, and millions of Americans are already behind in credit card and car payments. Delinquency rates in the US commercial mortgage market have tripled.
These will, most likely, bring down the massive financial bubble fueled over the past decade by the Fed.
It’s estimated that over 10 percent of companies in Europe are ‘zombies’. Their existence is also tightly connected to the existence of weak (or zombified) banks. And, remember that Europe holds the largest concentration of Global Systemically Important Banks, or G-SIBs, which means that the European banking crisis will “go global” in an instant.
The ECB’s stress test, published in October, showed that half of the biggest banks in the Eurozone would not survive if financial counterparties and some commercial clients pulled their money from the banks. This is exactly what happens in a recession, which has now definitely arrived based on the recent PMI figures.
The first estimate of China’s Q1 growth came at -6.8% (Y-o-Y), which is the largest decline since at least 1992. It’s now estimated that there could be as much as 205 million newly unemployed people unable to return to work or to find a job in China.
Considering these recent ghastly economic figures, we can safely assume that the Chinese banking sector is teetering on the edge of collapse.
China is desperately trying push more fiscal and monetary stimulus into the economy, but due to the collapse of global economic demand such attempts will be wholly inadequate. There are also already first signs of fire-sales commencing, e.g., in the Hong Kong real-estate markets.
Skyrocketing unemployment is very likely to collapse highly-inflated real estate and financial bubbles. These, combined with the crash in global demand, will result in a Chinese economic ‘hard landing’.
When corporate failures, or the Flood, truly begin, this will be visible both in the financial markets and in the public sector. Several sectors of the financial markets are likely to witness massive turbulence, collapsing prices and even complete implosion, similar to the recent cataclysm in the oil markets.
For example, Collateralized Loan Obligations, or CLOs, when faced by a deluge of corporate failures, and a resulting downgrade to “junk” status, can leave lenders unpaid due to weakly-written covenants. A few prominent defaults could eliminate market liquidity leading to the collapse of the entire $1.4 trillion CLO market.
The value of the holdings of public and private pension funds, charitable endowments, bank trust funds, insurance company general and variable accounts, and stock and bond mutual funds will crash in short order in the flood. Even lowly money-market funds may be at risk, just as they were in the Financial Crisis.
An utter economic collapse, Calamity, will follow.
If the devastating flood of corporate bankruptcies commences in May leading to bank runs and to a banking crisis by summer, there would be no real recovery in the global economy.
Massive global deflation will appear, led by an ugly chain of bank and corporate failures. Global liquidity will collapse and stock markets will crash in a spectacular fashion.
Due to both crashing capital markets and banking sector bankruptcies, joblessness and poverty are likely to explode. Simultaneously, government tax revenues will collapse as incomes retreat and capital gains evaporate.
As governments spending skyrockets in an orgy of Keynesian counter-cyclicality, national deficits will hit all-time highs on both an absolute and relative basis. Those central banks that have initiated debt monetization will have no alternative but to accelerate their programs. In their desperation, many other central banks are likely to follow.
Governments will try to save critically-important banks, which will require large-scale funding many countries—such as those in the Eurozone—cannot afford and will not be able to finance in paralyzed capital markets. This economic reality makes depositor bail-ins the only, if politically-unpalatable, option.
Confronted by new and harsh fiscal realities, pensions and other social security programs are likely to face serious cutbacks, by desperate governments. An economic calamity sets in.
However, even grimmer scenario exists. If the virus mutates and start to spread rapidly around the world during the fall of 2020 and continuing into the winter, we could be facing an utter economic annihilation.
Countries across the world would be forced to reinstate broad and draconian lockdowns leading to complete breakdown of supply-chains. Global logistics routes would be disrupted by huge numbers of sick (or frightened) employees and the strict closures of both factories and national borders.
These ghastly factors, combined with soaring unemployment, business failures and market turmoil would topple the global banking sector. Bank losses would be likely be so great that though depositor bail-ins would be enacted, they would be insufficient to keep banks from failing.
The European banking sector would collapse completely, followed by an implosion of the global financial order. Global commerce would evaporate. The world would succumb into utter economic annihilation.
This would be a scenario of an “economic apocalypse“. We could witness never-before-seen unemployment, wide-spread poverty and riots with some weaker countries succumbing into state of anarchy.
Unfortunately, things could get even worse, if the central bankers would enact the final step in their monetary destruction -scheme: the helicopter drops. They would bring an end to the monetary system as we currently know it.
If the full socialization of our economies and financial markets does not occur, we expect the global depression to last 3-5 years. The initial collapse is likely to be over within three years (2020-2022).
Thus, the path to recovery will depend crucially on how far the ‘cleansing’ of the economy, markets and financial sector is allowed to go. If the banking sector implodes completely, the economic deficit will naturally be made much deeper leading to a systemic crisis.
However, if the essential functions of the banking sector are sustained, especially in Europe, we could avoid the deepest malaise. Moreover, if unsound banks and “zombie” corporations are allowed to go under or are wound-down methodically, it will clear much of the malinvestment from the economy, creating the foundation for a strong and sustained recovery.
So, if we manage to return to the principles of the market economy including, most crucially, a return to undistorted price discovery in the capital markets, we are likely to see one of the most powerful recoveries in global economic history. It would be led by robotization and general technological innovation, which hard economic times tend to foster.
However, debt monetization, Modern Monetary Theory (“MMT”), helicopter drops and other money-conjuring schemes would corrupt the economy further making a sustained recovery impossible (see more from Q-Review 4/2019). This, unfortunately, is the path we currently are on.
Moreover, with the governments and the central banks assuming a much bigger role in the economy and society in this darker scenario, some form of fascism (which is, by definition, the merger of state and corporate power) would be the likely end-result of these developments.
We can do nothing more than hope that wise, courageous and far-sighted political leadership will spare us from that horrible fate.
Following the coronavirus outbreak, junk bond yield-spreads shot-up. They were first tamed by massive support operations launched by major central banks, but have refused to “normalize” (see Figure 1). It remains to be seen whether the ‘junk bond’ buying of the Fed will bring the spreads down.
It’s clear that the ‘zombified’ junk-rated companies cannot endure elevated yields and collapsing demand for very long before they start to fail. Yet, the massive collapse in demand, reflected in the flash PMI:s, will be the main driver of corporate bankruptcies worldwide.
Moreover, the Nikkei Asian Review has calculated that quarter of world’s largest companies are in risk of running out of cash, if there’s a 30% drop in sales lasting for a period of six months. That would result to defaults of large companies but also to a swathe of bankruptcies of smaller companies, sub-contractors, etc., which depend on the income streams from large, multinational companies.
We are in the interim stage between the Counterattack and the Flood. How fast the Flood stage fully engages depends on the effectiveness of the desperate actions of governments and central bankers across the globe: the last gasps of the Counterattack.
In any case, we are very close of the onset of the most destructive phase of this crisis. Prepare!
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